I. Introduction
1.1 This text aims to explain how we manage the portfolio of BHerman CIA, (an investment club, a structure very similar to an investment fund in Brazil) (“BHerman”). It is less about the investment style, and more about where such investment style leads us. A detailed explanation of our main style can be found in Everyday Deep Value in Brazil.
1.2 We have three types of readers: the ones who know a lot about finance (many of them know much more about it than we do), those who have little knowledge on the topic and the novices. If you know a lot, sorry, but you are in the wrong place. On the other hand, if you have little knowledge or are a novice, bear with us.
1.3 Here, you will find topics such as class of asset, portfolio formation, valuation, risk management, holding period, due diligence and much more. They will be directly or indirectly covered below[1]. To be as clear as possible, we will summarize our explanation in a short concluding sentence following each of the topics below.
II. A Holding Company Operating in Capital Markets
2.1 First of all, BHerman is a holding company operating in public capital markets. Wait a minute, isn’t it obvious? If you are an investment fund like vehicle, you are a holding company operating in public capital markets! Where is the relevant information here?
2.2 To say that BHerman is a holding company operating in public capital markets conveys a lot of information. First of all, we state very clearly the class of asset in which we invest. We invest in stocks of public companies only and not in startups, commodities or cryptocurrencies, for example. An important issue that is usually forgotten when we talk about investments in stocks is the mindset of the investor. Our mindset as a holding company is a long term one, oriented to business analysis. Here, the fact that we operate in public capital markets deserves some attention.
2.3 Broadly speaking, we can say that investments in capital markets can be in the market or in companies. A typical example of investments in the market are the ones based on technical analysis[2]. Think about a trend follower. This kind of investor does not care about the actual asset he buys or sells. Rather, he is worried about the trend. If the trend is to buy, he buys, and if the trend is to sell, he sells. On the other hand, a typical example of investments in companies are investments based on fundamental analysis[3]. The investor analyzes a certain company (bottom-up), makes an assessment about its market, strengths, financial position and decides to invest. The stock price may fluctuate, but the investor in companies does not care about it. His focus is on the company, and he believes that in the long term the company´s price will appreciate.
2.4 The chart below shows where we stand in this distinction between investments in the market and investment in companies. We invest in companies, but we are not a pure investment in companies investor. We pay very close attention to the price of a stock. What attracts us towards the investment in the market is not the technical analysis, it is the price of stocks.
2.5 At this point we can better explain what we do. BHerman is a holding company of cheaply traded public companies. We focus mainly on the price of stocks. The way we look at the price of stocks varies. A large part of our portfolio reflects the research presented in Everyday Deep Value in Brazil, yet some investments do not.
2.6 Now that you know what BHerman is, it is time to focus on our portfolio formation. It is the key to understand relevant issues of our operation such as valuation, due diligence and holding period.
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BHerman is a holding company of cheap stocks. |
III. Portfolio Formation or “One-Night Stand, Living Together and Marriage”
3.1 Portfolio formation is almost a synonym to investing. To invest is to form a portfolio. Even if you choose to have a single stock, you are forming a highly concentrated portfolio. The criteria chosen to form a portfolio defines everything about it. Remember that BHerman is a holding company focused on the price of its invested companies. Broadly speaking, our portfolio is theoretically divided into three sub-portfolios. What defines each of the sub-portfolios is more or less a combination of thesis, holding period and due diligence. If we consider that to invest is to form a relationship with certain companies, we can name our sub-portfolios in terms of relationships. Our sub-portfolios are: (i) one-night stand; (ii) living together; and (iii) marriage.
3.2 One-Night Stand. If you think about a one-night stand affair, it is easy to see that it is a simple relationship. It may evolve to something deeper, but it starts as something simple. In our case, what we call one-night stand portfolio is the implementation of the strategy described in Everyday Deep Value in Brazil, with a certain level of due diligence. In general, it means investing in a highly diversified portfolio of cheap stocks after a review of their final statements. The due diligence is limited and the initial holding period of each stock is at least one year. After one year, we reevaluate the portfolio and may or may not maintain a position.
3.3 The basic idea behind the deep value strategy is that if we systematically invest in cheap stocks, we will have superior returns. Markets overreact to news, depreciating the prices of certain stocks to a level that they become bargains. If you buy and hold them for some time, you will be rewarded with superior returns. Since financial statements can be messy, we believe that their review will add value to the strategy (for example, we exclude non-recurring revenues in our calculations).
3.4 Living Together. To live together with someone is something much more complex than a one-night stand affair. In our reality, it means a specific thesis (mainly opportunistic) that may take longer than one year to materialize and a deeper level of due diligence, if compared to the due diligence in the one-night stand portfolio. Since a deeper relationship is more difficult, the percentage of our full portfolio in this sub-portfolio tends to be limited.
3.5 Marriage. If living with someone is complex, getting married is even more complex. Marriage is the gold standard of long-term relationship. In our portfolio analogy, it pertains to stocks of companies that deserve to be bought and held. To have an investment like that involves much more than an opportunistic thesis and an even deeper due diligence. The marriage sub-portfolio tends to be an extremely limited one. It is hard to get married!
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We concentrate our investments in the strategy described in Everyday Deep Value in Brazil, but we may have positions following different theses as well. In any case, the stocks should be cheap. In general, our holding period is of at least one year. We necessarily make some revisions of the financial statements of the companies in which we invest. |
IV. Price – What is Cheap and Why is it Cheap?
4.1 The questions above are very hard to answer. They go into the heart of investing. The reality is that both questions have no answer, but we can work around them.
4.2 One of the tricks regarding the question What is cheap? is that it can be answered in relative terms. By relative terms we mean to check if something is cheap when compared to another thing. Financial markets offer lots of data that can be used in this kind of comparison. An important part of our analysis is based on the so called value metrics. Although this summary does not intend to cover details on them, we will talk about three metrics in particular: (i) price to book (P/B); (ii) liquidation value; and (iv) earnings yield. Such metrics will give you a flavor of what we do.
4.3 Price to book – P/B. Accounting is an underrated discipline. The accounting information is of extreme importance to investors. Financial statements convey a lot of useful information for the ones who read them. P/B is the relationship between the price of a company and its book value. Maybe this is the most traditional of all value investing metrics.
4.4 Theoretically speaking, book value is the amount that remains to the owners of a company after the payment of all creditors. Imagine a stock that has a book value of 10 and a current price of 4. The P/B is 0,4. In theory, it means that if the company is liquidated, stockholders will receive a premium of 6. Too good to be true, right? Of course! This simplistic explanation tells you what P/B is, not how to make money with it! Liquidation is very rare. Only in very specific situations companies are effectively liquidated. Also, if an actual liquidation were to occur, the gap between price and book value will not be that large.
4.5 P/B as a metric makes sense in some areas, such as real estate operators and real estate developers. In such companies, the value of assets and liabilities tend to reflect values close to current values. P/B is good to analyze large price dislocations in industries where the indicator has relevance. On the other hand, in companies where intangibles are relevant, P/B has limited relevance.
4.6 Liquidation value. Liquidation value is a form of P/B. Here, instead of looking only at the P/B ratio, we make a more detailed assessment of what would be the value of a company if it were liquidated. In this kind of analysis, among other things, we consider: (i) realization value of subsidiaries or investments; (ii) capital gains taxes the company would pay if its assets were liquidated; (iii) use of tax credits; (iv) acceleration of debts and effects of debt covenants in case of liquidation of a company; and (v) many other issues. Once again, it is extremely rare that a company is liquidated, but a company trading at a price that is lower than its liquidation value can be a strong indicator that the price is cheap.
4.7 Earnings Yield – EY. We explain this metric in detail in Everyday Deep Value in Brazil (see Pillar 5 – The Metric). In short, EY shows the yield of a company assets[4]. It makes sense to buy companies that have the highest yielding assets. If investors seek after superior returns, it is reasonable to imagine that soon or later they will invest in such companies.
4.8 All the metrics above are examples of the metrics we use. They have several shortcomings! Think about metrics as an airplane control panel. They provide a lot of information, but many of them must be read together to give you relevant information. Metrics, if not analyzed in a specific context, may be extremely misleading.
4.9 It is hard to say why something is cheap. The cheapness of a stock may be well deserved. The question on why a stock is cheap is less important than it seems. In many cases, stocks are cheap for a temporary reason and such reason will pass. The trick is to buy something that is cheap for any reason and make money with it. For example, in our “one-night stand” portfolio, we have a highly diversified portfolio and a limited holding period[5]. We are sure we are making some mistakes in this portfolio, but diversification and temporary holding period address them. As to the “living together” portfolio, only extreme bargains justify the investment.
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Several metrics can be used to choose stocks. Metrics should be seen as the control panel of an airplane and be analyzed together. Earnings Yield is a powerful metric to a systematic portfolio. To see if something is cheap, it is better to wait for extreme price dislocations. Diversification and limited holding periods are essential. |
V. Boring, Contrarian and Size Doesn’t Matter (But Small is Beautifull!)
5.1 Since we buy cheap, we do not buy the hype. Over the last years, this approach meant not investing in companies such as WEG, Magazine Luiza or Nubank. We have no prejudice against such companies and make no assessment about them. They are all investible companies at an appropriate price.
5.2 We tend to invest in less known (boring) companies, but we also may have some popular names. We are size agnostics as well. We invest in large, mid and small caps. Since we are small, we can take advantage of smaller caps, but we have no market cap preference.
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We do not follow the hype. We tend to invest in less known companies, but also invest in popular ones. We are market cap agnostics. |
VI. It is all Equity
6.1 We do not use leverage in our investments. BHerman is not only a cheap stock holding company, but also conservatively funded. It means that it has no financial creditors, only investors[6]. We share with our investors the same equity risk.
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We do not use leverage. |
VII. Always Invested (With Sporadic and Limited Hedge)
7.1 We do not time the market, which means that we are always invested in stocks. What we do in some exceptional circumstances is to buy some protection when we think protection is cheap[7]. Overtime, we learned that it should be done only in really exceptional circumstances. Otherwise, buying protection is a waste of money.
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BHerman is always invested in stocks but may have some hedge in exceptional circumstances. |
VIII. Final Remarks – Remember Rocky Balboa
8.1 What we have above is a simplified description of what we do. However, there is something missing. How do we and our investors feel? It may appear an out of place question, but it is not. Investments are much more about psychology that math. It does not matter how accurate a model is if the investor panics.
8.2 We feel comfortable investing in a highly diversified portfolio of cheap (and mostly boring) companies. Investing is a long-term game in which survival is the key. Pop culture is undervalued as a source of wisdom. We fully agree with Rocky Balboa when he says: It’s not about how hard you hit. It’s about how hard you can get hit and keep moving forward. How much you can take and keep moving forward. We minimize our chances of error if we buy cheap. We also minimize our due diligence risks if we have relatively short holding periods (since we have a long-term mentality, one year is a short period of time). By investing this way, we are in a better position to get hit and keep moving forward.
8.3 What to do in cases of extreme fear? Well, this time let’s hear what Duke had to say to Rocky: You’re gonna have to go through hell, worse than any nightmare you’ve ever dreamed. But when it’s over, I know you’ll be the one standing. You know what you have to do. Do it. In times of crises, brace for impact. This too shall pass.
[1] All topics here such as capital markets theory, investment philosophies, valuation metrics, accounting, portfolio formation, hedge and investor psychology are grossly oversimplified in this text. However, they are much more complex. In any case, we want to be as simple as possible to explain what we do.
[2] Technical analysis is based on market information only, mainly the stock price. No time is spent analyzing the financials of a company if the investor follows technical analysis.
[3] Fundamental analysis is based on the analysis of the companies financial statements. Accounting issues are of utmost importance for the fundamental analyst.
[4] This is a tremendous oversimplification, especially if taken out of its context, much better explained in Everyday Deep Value in Brazil. Another way of looking at EY is to treat is as a multiple. We prefer to use it as a yield because, in our opinion, it is a more intuitive way of understanding its meaning. We know that multiples do not exist in a vacuum and that some companies tend to have higher multiples than others. However, this is a discussion well beyond the scope of this text.
[5] We also have what we call hygiene factors, such as maximum debt and liquidity.
[6] In exceptional circumstances we may have small short positions. But note that in such cases the leverage is a consequence of an investment instead of being a form of funding.
[7] Basically, in the form of put options against Ibovespa (the main Brazilian stock market index).